Monthly economic commentary: January 2016

Market insights

Economic and market highlights

Recent data on the United States industrial sector was not particularly encouraging. Industrial production has seen its third consecutive monthly decline. Manufacturing activity remains weak, with four of the last five months showing contractions. With output of the sector down 1.8 per cent since this time last year, we are witnessing the slowest pace of growth since the crisis in 2008. The US economy is resilient, but weak global growth and a protracted slump in equities could undermine this. Also, risks posed by a strong US dollar are diminishing as its rally slows.

In the Eurozone, the labour market continues to plod along the road to recovery as the unemployment rate improved to 10.4 per cent, which is its lowest level since 2011. The threat of disinflation remains as the fall in energy prices washes through the economy. However, household disposable incomes should begin to recover as tighter labour markets produce wage increases. While the European Central Bank policy easing measures are grounds for optimism, risks from political uncertainty in the region and fragile global growth persist. In the United Kingdom, a preliminary estimate of gross domestic product (GDP) growth in the fourth quarter of 2015 was 0.5 per cent. Services sector, specifically business and financial services, is the only private economic sector to see an increase in output, while production and construction were a drag. The fourth quarter will likely be an improvement on third quarter, but when the final numbers are in, it is expected growth will continue below the long run trend.

The Bank of Japan (BoJ) has recently surprised markets by implementing negative interest rate policy in the hope that the currency continues to weaken and assist in Japan’s long-running battle against disinflation and deflation. It joins a number of other central banks as the fifth institution to implement this unconventional policy.

China grew by 6.8 per cent year-on-year in the fourth quarter of 2015, fractionally less than the “official” target of 7 per cent. The well-documented, gradual slowdown of its manufacturing sector and broader economy continues.

Bonds

Developed economy yield curves have seen a downward shift across the board, with US, UK, Europe, Japan and Australia all finishing lower. Since the end of 2015, US 10-yr bond yields have slipped from 2.31 per cent to 1.75 per cent with barely a pause. European, UK and Australian yields have all followed suit with remarkable synchronicity. With equity market volatility increasing and defaults in energy and high yield credit escalating, investors are shedding risk and returning to sovereign and AAA-rated debt, causing yields spreads between high and low quality issues to widen dramatically. In response to the introduction of negative interest rates in Japan, 10-year yields there have fallen dramatically.

Equities

The MSCI World Index of developed market equities spent most of the month in a risk-aversion induced sell off with the index losing 3.4 per cent in Australian dollar terms. In local currency terms, the S&P500 fell 5.1 per cent, while London’s FTSE 100 and Germany’s DAX shed 2.5 per cent and 8.8 per cent. The S&P/ASX200 was not spared the rout, declining 5.5 per cent. Canada fared better than most, losing 1.4 per cent. Examining Canada’s MSCI sector indices, it becomes clear that the solid performance of the nation’s Financial and Energy sectors, which together account for around 60 per cent of the market, were the primary reason for this.

Currencies

“Take the stairs up and the elevator down” is a cliché typically applied to equity markets, although it can equally be applied to the performance of the Australian dollar over the past four months. The final quarter of 2015 was spent with the currency grinding out gains with the Reserve Bank of Australia (RBA) reluctant to cut interest rates and strong employment data guaranteeing RBA inertia. However, in the first month of 2016, with the market unable to decouple the fortunes of China and Australia and equity markets volatility on the rise, the Australian dollar’s status as a risk-on currency has been reaffirmed with flows clearly indicating a desire for safe harbour elsewhere.

The US dollar trade-weighted index gained 0.9 per cent. Against the US dollar, the euro fell 0.4 per cent, pound sterling lost 3.8 per cent, while the yen has shed 0.6 per cent.

Negative interest rates are becoming "conventional monetary policy"

On 18th January, Governor Kuroda of the Bank of Japan (BoJ) announced in parliament that the central bank board were not considering a cut in the current 0.0 per cent rate applied to excess reserves deposited by banks with the BoJ. However, on 29th January, a policy was introduced that divided these balances with the BoJ into three tiers, one of which would now attract a new, negative interest rate. The implementation of this policy the BoJ makes it the fifth central bank resorting to this relatively new form of unconventional policy.

Now, the European Central Bank (ECB), Swiss National Bank, Danmarks Nationalbank, Sweden’s Riksbank and the Bank of Japan have all adopted negative interest rates of one form or another to drive down market interest rates and weaken their respective currencies. Unfortunately for Sweden and Denmark, the Eurozone is a key trading partner and attempts to weaken the local currency in order to stimulate growth via exports have been somewhat neutralised by the ECB implementing negative rates of their own to weaken the euro.

When economist John Maynard Keynes published The General Theory of Employment, Interest and Money in 1936, he coined the expression “zero lower bound” to refer to the fact that nominal interest rates could not go below zero. Some eighty years later, and we have central banks flouting this economic law all over the place. Clearly, this tenet has been invalidated, but while the lower bound is clearly not zero, the existence of arbitrage profits available to those hoarding cash should signal where it is.

The imperative to adopt negative interest rates has been a whittling away of other monetary policy options and a persistent decline in inflationary pressure. The transmission mechanism of interest rates to the broader economy does not change much as they move into negative territory. Whether rates are low or below zero, a principal objective is to depress the value of the currency. Initially, it facilitates a “carry trade”, as individuals and businesses borrow where interest rates are negative and invest where they are higher and can earn the spread between the rate at which they borrow and the rate they earn. This carry trade happens to such an extent that it can also cause the currency to weaken, augmenting profits on the carry trade and further promoting the mandated objectives of the central bank, which in many cases is price stability. The weak currency stimulates trade by making the country’s exports cheaper and more competitive. A falling currency causes the price of imports to increase, producing inflation.

Beyond weakening the currency, negative interest rates may promote the growth of credit and money supply. The success of this particular channel in transmitting the effect of negative interest rates depends on the willingness of financial institutions to pass on the lower rates to customers; depositors and borrowers. Assuming interest rates on deposit products fall, demand for assets with a higher yield increases, and we see asset price inflation. Borrowers may also see a decline in debt servicing costs. In Denmark, we see the perverse situation in which some borrowers are actually receiving interest on their mortgages. Admittedly, it’s not a widespread phenomenon but the impact of ultra low or negative rates can be observed in the acceleration of house price growth in Copenhagen, with lucky homeowners benefitting from a generous serving of the wealth effect.

However, there might be unintended consequences to negative interest rates, and these are largely determined by the reaction of financial institutions to the central bank policy- do they absorb the losses or pass them on? Unfortunately, there is not a great deal of empirical evidence available on monetary policy of this nature, so our understanding of how it works in practice is limited to the very recent past. On the face of it, negative interest rates will mean banks that deposit excess reserves with the central bank will be charged to do so as a negative interest rate will be levied on deposit facilities banks use for stashing money overnight. If the charge is too high, these banks will switch excess reserves to cash rather than send it to the reserve bank. This creates a unique problem: where should all this cash be stored? Logistical problems abound, such as the physical transfer of cash between banks for settlement.

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Source: MWM Research, Oxford Economics, February 2016

Rather than be charged to deposit money with the central bank, or convert excess holdings to cash, banks may lend funds in short term money markets. With the immense weight of money chasing better yields, short term money market interest rates get driven lower. When short term rates get too low, banks are forced out along the maturity curve, lending for longer periods than they might ideally like. Ultimately, they are limited by liquidity requirements.

It is also a possibility that the relentless search for assets that produce a positive return leads to asset price bubbles and increased financial market volatility. For now, at least, the enormous financial experiment has not produced disastrous consequences and, as a result, we will likely see central banks push the envelope of what can be achieved with monetary policy as rates gradually move further into negative territory.

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